Dark pools, already shrouded in mystery and eyed with some distrust, made headlines this past fall when Pipeline Trading, one of the largest of the private networks, was caught trading ahead of its customers, raising alarm bells on the buy side and speculation about a pending regulatory crackdown. But perhaps surprisingly, in the six months since Pipeline was fined $1.2 million by the SEC in October 2011 — for not disclosing that an automated trading affiliate was matching the vast majority of customer orders — there has been no perceptible backlash.
"Pipeline was an outlier, as opposed to a tendency that was going on in all dark pools," insists Jonathan Kellner, president of Instinet Americas, an agency broker that operates four dark pools. Further, though there has been talk of regulatory scrutiny of dark pools, sources say the SEC is busy writing Dodd-Frank rules and is more likely to address high-frequency trading before turning its attention to dark pools.
Still, the Pipeline incident has been a wake-up call for the buy side, driving firms to ask more questions about executions and work to better understand how dark pools operate. "It has pushed the buy side to focus on order handling and order routing," says Kellner. While traders were heading in that direction anyway, he adds, the Pipeline issue "accelerated it and shed more light on the need for transparency and the fact that people should make sure they know where their orders are routed."
Despite any heightened concern, however, in the current low-volume environment, buy-side traders appear to be using dark pools more than ever. With U.S. equity volumes averaging around 6.8 billion shares per day, down 14 percent from Q1 2011, traders at asset management firms and hedge funds are seeking liquidity in dark pools. "With volatility where it is, volume in dark pools picks up," explains Kellner. "The lower the volatility, the more passive people are going to be, and the more likely there will be more trading in dark pools."
Dark pools accounted for 13 percent of U.S. equity volume in March, according to estimates by Tabb Group. Typically, dark pool market share has been 10 percent to 12 percent of equity volume, but in January this year, it hit a high of 14 percent, according to Cheyenne Morgan, a senior analyst at Tabb Group who tracks equity volume for dark and lit markets. "People continue to use them and are more comfortable trading in the dark," she says. "That's the reason for the higher market share."
But coupled with the growing volume of internalized trades -- which occur when brokers match orders on sales trading desks or via algorithms before routing them to trading venues -- the growth of dark pools is stoking a long-simmering controversy over transparency into executions. Nearly one-third of U.S. equity flow was traded away from exchanges during the first quarter of 2012, estimates Tabb Group. And Tabb Group founder and CEO Larry Tabb says buy-side traders are turning to internalizers -- big brokers that match trades internally -- and dark pools much earlier in the trading process.
[Tabb Group offers the real reasons why 33 percent of U.S. equities volume is traded off-exchange.]
Some of the exchanges argue that internalization and dark pool flows obsure price discovery, hurting the markets. "The dark pools continue to be a frustration for exchanges," says Instinet's Kellner. And their frustration, he adds, is exacerbated by the fact that "dark pools are more lightly regulated."
Analyst firm KBW, which estimates that nearly 34 percent of U.S. cash equity trading activity has been matched off-exchange so far this year, specifically noted in a March report that internalization is causing the NYSE to lose market share. "NYX in particular has lost market share in Tape A securities executed on the NYSE floor as dark pool matching has increased on lower volatility," according to KBW. In Q1 2012, the NYSE holds a 23.5 percent market share, compared to 26.2 percent a year ago.
More and more institutions, however, are finding value in dark pools. Traditional asset managers increasingly are turning to dark pools to prevent information leakage and avoid moving the market with large orders and to contend with high-frequency traders. In a sign that traders value block pools that cater to long-only managers, Liquidnet reported that its U.S. average daily volume rose 25 percent in the first quarter of the year, to 51 million shares, compared to just a quarter earlier, while overall market volumes were down 8 percent over the same period.